Friday, November 11, 2011

In the wake of the financial crisis, the PCAOB Pricing Sources Task Force is examining issues pertaining to fair value measurements of financial instruments and the use of third-party pricing sources. The Task Force is getting an overview of issuers’ processes and controls over information obtained from pricing sources, as well as the nature and extent of information pricing sources provide to issuers and auditors. The Task Force is also examining the pricing sources’ processes and controls over the data used in valuation of financial instruments; and auditor’s procedures in connection with the use of information produced by pricing sources in a financial statement audit. Five members of the Standing Advisory Group serve on the Task Force: former SEC Chief Accountant Lynn Turner, Mike Gallagher of PricewaterhouseCoopers, Neri Bukspan of S&P, Gaylen Hansen of Ehrhardt Keefe Steiner & Hottman, and Jeffrey Mahoney of the Council of Institutional Investors.

There are three levels of fair value pricing of securities. Level 1 of the fair value hierarchy prioritizes quoted prices in active markets for identical assets or liabilities. In the absence of quoted prices in active markets for identical assets or liabilities, the fair value hierarchy allows for the use of valuation techniques, such as pricing models that incorporate a combination of other inputs. Those other inputs consist of observable inputs that are reasonably available in the circumstances, including quoted prices in markets for comparable assets or liabilities (Level 2), and unobservable inputs in illiquid markets (Level 3).

Two members of the PCAOB staff, Deputy Chief Auditor Greg Scates and Associate Chief Auditor Gregg Fletcher discussed the work of the Task Force in a presentation to the SAG. A sample of financial instruments within different asset classes were priced by the pricing source representatives on the Task Force. For each financial instrument, the Task Force discussed how the pricing sources determined the prices for individual instruments; the valuation technique, the proprietary nature of the models, and the assumptive data used by the pricing sources. The Task Force also examined why the valuations were similar or different.

The Task Force found that different types of pricing sources provide a variety of services to issuers and auditors and that issuers’ use of third-party pricing information to value financial instruments varies. Some issuers use information from pricing sources as a data point to corroborate their internal models, while other issuers rely on information obtained from pricing sources for their fair value measurements. Issuers also may use a combination of the above methods for different financial instruments held by the issuer

It is important for the issuer’s portfolio to be classified into separate categories with similar risks and characteristics so that the auditor can understand the risks within each category and focus attention on those instruments with higher risks of material misstatement. In addition, a SAS 70 report could provide some assurance over the controls at a pricing service. However, from an audit standpoint, it would not provide sufficient appropriate audit evidence to support the fair value measurements of financial instruments.

Mr. Fletcher noted that the pricing services try to base the fair value estimate on observable inputs. Level 2 is generally where the pricing sources come into play. The Associate Chief Auditor said that pricing services will give a price to a client and the client can challenge it. The Task Force has found that in 25 percent of the time, the pricing service will change a challenged estimate. Auditors use pricing services, as well as their own internal experts, and generally use a pricing service different from the one the company uses.

Mr. Scates said that the pricing service must have strong evidence to change a fair value price on a particular security. They have too see evidence. To a question from SAG member Sam Ranzilla of KPMG as to what the percentage of the change in the price generally was, Mr. Fletcher replied that the pricing service do not generally publish or track magnitude.

SAG member Wayne Colins of BDO asked if, after the pricing question is resolved do the pricing services make an adjustment to their model. The PCAOB staff replied that when the pricing services make a change it is often because they are presented with an observable input. Thus, the pricing change is not usually based on a flaw in their model, but because they received a market input. The PCAOB staff is digesting the information gleaned from the Task Force before putting out any guidance in this area.

SAG member Arnold Hanish of Eli Lilly noted that this area poses significant audit risk and should have a high priority. He said that management has a duty to ensure that all of the controls are in place, especially if there are investments in hybrid instruments. This is also an area ripe for material weaknesses for companies without adequate in-house staff to police the pricing services.